Comparison of Local Volatility and Stochastic Volatility Models in

Pricing Path-Dependent Products

SRIJAN CHAUDHURY
April 21, 2024

Introduction
Local Volatility Models (LVM) and Stochastic Volatility Models (SVM) are 2 well-known modelling
frameworks. Both of these improve upon the assumptions of the Black Scholes Merton (BSM) model
and are able to generate volatility smile/skews as well as fat-tailed asset distributions with the help
of a volatility function which is both time & state-dependent. In fact, if we assume the Stock and
volatility processes are uncorrelated, the stochastic dynamics of the vol tends to perturb
symmetrically the dynamics of the stock making both large downwards and upwards variations more
likely than in a lognormal process, and also generating clusters of very low volatility. This is actually
what is called fat tails (which does not imply only larger downwards and upwards variations because
this can be arrived at just by increasing Black and Scholes volatility) and implies symmetric increases
of the Black volatility curve on both sides of the strike range. We can have another effect of
stochastic volatility, if we only decide to set a non-zero correlation ρ. In this case the perturbation
due to stochastic volatility can, for example, be higher when forward rates are decreasing (case ρ <
0). This makes the implied volatility curve decrease when plotted against the strike, a shape which is
characteristic of the equity option market and often called skew.

Let’s say we have a general LVM where the asset price S follows the dynamics as given below

where σ(S; t) is the volatility of S. The variable r(t) is the risk-free rate at time t and q(t) is the
dividend yield at time t

Then the value of any Derivative f dependent on the asset price satisfies the below differential
equation

The above LVM Partial Differential Equation (PDE) is arrived at in a similar way as the one for the
price of an option under the BSM model.

Inferring info on Underlying dynamics from Market Smiles

The fundamental idea of learning something about the dynamics of the stock price from the shape of
the Implied vol smile that it generates comes from the Breeden-Litzenberger formula. The concept is
very simple – As the payoff of a call option depends on the Expectation of the Stock Price at the
option maturity, then if we are given the set of all call options prices in the market, then we can
perform some simple mathematical steps (involving differentiation of the payoff) & infer the
Probability distribution of the Stock Price at the Maturity date. Here we leverage the fact that the
Expectation of any Random Variable can be written as the Integral of the Variable with its density
function. Below are the formulae involved in those mathematical steps detailed above.

Here f0,T(x) is the probability density, under the pricing measure, of S(T ) given information at time 0,
namely

Now, the 2nd order derivative of the payoff wrt the strike K eventually equates to the density function

By interpolating and extrapolating the quoted options, we can artificially create a continuum of
prices and get a density which is consistent with all quoted options. This can be repeated for all
quoted maturities Ti, and then a time interpolation and extrapolation can also be computed in order
to have a continuum of σTK both in K and in T
So, now that we’ve inferred the density, how can we make use of it? Well, here’s where the well-
known insight from Bruno Dupire comes into the picture as we’ll see in the next section.

Estimating the Local Vol Function by leveraging the Fokker-Planck Equation

Dupire stated that once we’ve inferred the density as we did above, then we can find a unique risk-
neutral diffusion process that generates those densities. What this means in layman terms is that say
we have assumed our stock price is driven by a local volatility process but we don’t know the full
functional form for the same. Then, that is exactly what Dupire claims can be inferred from the
Terminal distribution of the Stock prices. How is that achieved? Well, this is where we make use of
the Fokker-Planck (FP) equation. To put it very simply, FP equation specifies a mathematical condition
which is to be satisfied by the Probability Density Function of a Random Variable. The specific
condition depends on the SDE of the Random Variable & it comes from

dy = A(y,t)dt + B(y,t)dW

Let’s define the Transition Probability Density function p(y,t :y`,t`) which basically tells us the
probability that the random variable y lies between a and b at time t` in the future, given that it
started out with value y at time t. Then p(y,t :y`,t`) is such that
𝑏
Prob (a < y < b at time t`|y at time t) = ∫𝑎 p(y, t ∶ y`, t`)dy`
Then as per the FP equation, this function p(y,t :y`,t`) has to satisfy the below Partial Differential
Equation

𝜕𝑝 1 𝜕2 2
𝜕𝑝
=( ) (𝐵 (𝑦`, 𝑡`) 𝑝) − (𝐴(𝑦`, 𝑡`)𝑝)
𝜕𝑡` 2 𝜕𝑦`2 𝜕𝑡`
The proof of where this Partial Differential Equation above comes from is more detailed than can be
shown without deviating from our main topic. However, the logic for the same is quite easy to grasp.

Below I outline a very simple way to prove this

 We can simply build a trinomial tree traversed by our Random variable y whose dynamics we
defined above.
 Then we can find a relation between the probabilities of the up/down movements within the
tree and the A & B terms in the dynamics of y. This can be done by moment matching which
simply means matching the mean & standard deviation of the move between 2 time steps in
the tree with those
 Finally, we find a relation between the probabilities of the up/down movements & the
Transition Probability Density function p(y,t :y`,t`) by leveraging the fact that the probability
of being at a certain node y` at time t` in the tree is related to the probabilities of being at
each of the 3 possible previous nodes and then each of them moving in the direction
required to reach y’

Thus, after this short digression to get an intuition of how we arrive at the Fokker-Planck equation,
let’s now return back to the task of leveraging it to calculate our local volatility function.

Now again instead of throwing a bunch of confusing equations here, as always, I’ll first outline the
approach to arrive at the local vol function & then show you the equations which would then
become very easy to follow. So, below are the broad steps involved -

 We saw above how the FP Equation gives us a relation between the 1st order derivative of
the function p(y,t :y`,t`) wrt time and the 2nd order derivative of p(y,t :y`,t`) wrt the random
variable y`. When we substitute the drift & diffusion terms A(y`,t) & B(y`,t) with their actual
functional forms, we might get the 1st order derivative of p(y,t :y`,t`) wrt y` as well. We’ll
make use of this at a later step
 We already would’ve calculated the 1st & 2nd order derivatives of the Call Price wrt the Strike
while deriving the Breeden-Litzenberger formula. We’ll make use of those derivatives here
again.
 Now, we’ll start by taking the 1st derivative of the Call price wrt time. That gives us an
equation in terms of the 1st derivative of the Probability Density function wrt time for which
we can substitute the relation we found in the 1st step above using FP Equation.
 The previous point results in an integral which when integrated gives a relation between the
1st derivative of the Call price wrt time and the 1st & 2nd order derivatives of the Call Price wrt
the Strike. Hence, now we can make use of the values of the derivatives calculated in the 2nd
point above to substitute here.
 In the previous step, we can even get rid of the term with the 1st derivative of the Call Price
wrt the Strike if we express the option price as a function of the forward price instead of the
sport price. Thus, with this final adjustment, we get a very neat solution for the local vol
function in terms of the derivatives of the Call price wrt time & strike.
Now as promised, below are the actual stepwise mathematical equations involved here which should
now be easy to follow. Here ϕ corresponds to the Probability density function while St , K & F have
their usual meanings of Stock price at time t, Strike price & Forward Price respectively. σ is of course
the Local vol function we’re looking for.

1. The Fokker-Planck Equation

2. The 1st & 2nd order derivatives of the Call Price wrt the Strike

3. The 1st derivative of the Call price wrt time

4. Performing Integration by parts twice on the above gives:

5. The final solution for the Local vol after expressing the option price as a function of
the forward price

So, given a complete set of European option prices for all strikes and expirations, local volatilities are
given uniquely by the above equation The above process is thus a very novel finding which effectively
lets us calibrate Local vol models & price derivative products using it. But there is a small catch here
which we discuss in the next section.
 Is a density function unique to a model?
As ground breaking as Dupire’s idea is, there is a very subtle nuance here that we just can’t afford to
ignore. And that happens to be the realization that - Different models can generate the same
distribution. Let me give you a very simple yet very effective example to demonstrate what I mean
when I say that. Say we have 2 models A & B which try to model the evolution of a Random Variable
X across time. Let’s denote the estimates of X at different times as per Model A as XA(t1), XA(t2) and so
on. And the same from Model B as XB(t1), XB(t2) and so on. Let’s set the initial value of X as X(0) i.e
XA(0)= XB(0)= X(0). Now, Model A is such that at each time step, it simply predicts the value of X to be
a Standard Normal Variable that is independent of the value at the previous time step. So,
mathematically this can be shown as below.

Now, compared to that, let’s make Model B such that its predictions have less of a random
component to them. How do we do that? Well, instead of predicting a new Standard Normal Variable
at each timestep for X as we had under Model A, we let only X at t1 be estimated that way. And then
we fix the value of X at all subsequent timesteps to be equal to its value at t1. What this effectively
means is that once we know XB (t1), then we completely know XB (t2), XB (t3) & so on. So, now it’s very
apparent to see how models A & B differ. Under Model A, at every step we have a new realization of
a Random Variable as the estimate of X. While under Model B, only at t1, we estimate X with a new
realization & then every estimate of X post t1 depends solely on the estimate at t1. So, as I said
before, Model B is a version of Model A with much less randomness.

But now here’s a very interesting observation on the 2 models above. Even though, we can clearly
see how different these 2 models are, they still predict the same marginal distributions for their
outputs. What does that mean? Well, what is the distribution of X under A at t1,t2,t3 & so on? It’s a
Standard Normal Distribution. But, then what is the distribution of X under B at t1,t2,t3 & so on? That
is also a Standard Normal Distribution. How so? Well, given that XB (t1) is clearly a Standard Normal
Variable, that makes XB (t2), XB (t3) etc Standard Normal Variables as well as we set then equal to XB
(t1). However, note that while XA (t2) & XB (t2) have the exact same marginal distribution, they need
not necessarily have the same value i.e XA (t2) = XB (t2) need not always be true. So, essentially the
idea I want to stress on here is that 2 different models can generate values with the same marginal
distribution & hence, it’s not really possible to infer the model behind the process that generates a
particular distribution. This would lead to model risk because a Modeler who sees 2 models
generating the same Unconditional distribution might be led to incorrectly believe that the 2 models
are exactly similar in every other aspect as well – a belief which if acted upon, could lead to
disastrous consequence as we’ll see later.

So, this then raises an interesting question if we extrapolate the above idea. Is it possible that the
same distribution can be generated by an LVM models as well as an SVM model? Indeed, it’s
possible. We can have a LVM & an SVM say Heston Model calibrate to the same set of European
options. So, we may not be able to distinguish between the 2 just on the basis of that alone. Where
the difference due to usage of different models would manifest itself is when we try to price
products which depend on not just the terminal distribution of the stock price but also on the
transition distribution of the stock price i.e. distribution of the stock price at a certain time
conditional on it having a certain value at an earlier time. If 2 models agree on the marginal
distribution, the only thing that tells us is that they agree on European option prices. But what about
exotic prices? Let’s see some empirical testing done by reputed Quants to answer this question.

Pricing Tests
Given that the LVM is frequently used to value exotic options on stock indices and exchange rates,
these products can be used to test the divergence between the prices generated by LVM & SVM. For
illustration purposes, the prices from the BSM model are also added to this comparison. Now, we
usually perform calibration by attempting to fit the model prices to a set of market instruments.
However, given that here we want to ensure a like-for-like comparison between models which have
exactly similar calibration power to European options, we’ll calibrate the LVM to some Europeans
prices generated using the SVM against which we’ll be comparing it. We could’ve done it the other
way around as well but we know, LVM calibrates to Europeans much easily than SVM. These tests
were performed by Hull, J.C. and Suo, W in their paper titled “A methodology for assessing model risk and its
applications to the implied volatility function model”. All the test results discussed hereon can be found in
detail in the Table 3,4 & 5 in the Appendix section of this paper. Options with S&P500 as the
underlying asset were chosen for these tests. Given its popularity in the Equities modelling, the
Heston (1993) model was chosen to generate the SVM prices here. The SVM prices were calculated
using Monte Carlo Simulations while the LVM prices were calculated using an implicit Crank-
Nicholson Finite Difference method (FDM) applied to the LVM PDE mentioned before. For those new
to this term, FDM is a very popular approach to solve PDEs by evaluating the financial product at
various node points of a space-time grid & then approximating the partial derivatives of the product
price wrt time & asset price as in the below.

Although it’s not really important here, those interested in the mathematical details of this FDM
implementation are referred to the paper “The equity option volatility smile: an implicit finite-difference
approach” by Andersen and Brotherton-Ratcliffe.

Call-on-Call Compound options

We start with an illustrative product which can demonstrate the impact of pricing it using models
which agree on Terminal densities but differ on conditional densities. We take a Call-on-Call
Compound option which is simply an option with its underlying as another option. Here the buyer
has the right at time T1 to pay K1 and obtain a call option to buy the asset for a strike price K2 at T2. It
is just as the name implies – It’s a call option for which the underlying asset is another call option. So,
now as a shorthand, let’s denote the Call option which serves as the underlying asset here as the
Inner call & the other one as the Outer Call, & we then denote the value of the Inner call as Call(T1)

Then, the payoff of Outer call can be written as

Above equation is simply a version of the Standard Call option payoff formula with the Stock price
substituted by the Price of the Inner Call option. And then we can expand it further by replacing
Call(T1) with the call option payoff formula and finally rewriting all the Expectation terms in terms of
the Probability distributions of the respective variables.

What the above formulation shows us is that the value of this Call-on-Call option is dependent not
only on the Probability distribution of the terminal Stock price at T2 but also on the Transition density
f T1,T2 given the value of the variables at T1. This is thus a simple example of a derivative dependent on
1 conditional distribution.

In their tests, Hull and Suo price a call-on-call compound option with T1 = 1y, T2 = 2y, K2 = S(0) and a
range of K1. They find that in relevant cases the difference between the LVM price and the SVM price
is less than 2% of the SVM price. The difference, and thus the model risk, are small, particularly if we
compare it with the much bigger error that one would make with a Black and Scholes model
calibrated to the at-the-money European options only. The difference between LVM and SVM,
additionally, is less than 1% of S(0), the initial stock price.

You’d recall we also did mention we’d see how these prices above compare with the ones from BSM.
Well, in contrast to the relatively moderate differences seen between LVM & SVM above, the BSM
model, on the other hand, performs quite badly. For high values of the strike price, K1, it significantly
overprices our test compound option on the stock index data. The reason is that, when K1is high, the
first call option is exercised only when the asset price is very high at time T1. Consider the stock index
data. Due to the volatility skew phenomenon that we know exists in the Equities space, the implied
volatility is a declining function of the strike price. As a result, the probability distribution of the asset
price at time T1 has a heavier left tail and a less heavy right tail than a lognormal distribution when
the latter is calculated using the at-the-money volatility, and very high asset prices are much less
likely than they are under the BSM model. This means that the first option is much more likely to be
exercised at time T1 in the Black–Scholes world than in the assumed true world.

Traders sometimes try to make the Black–Scholes model work for compound options by adjusting
the volatility. Sometimes they use two different volatilities, one for the period between time zero and
time T1 and the other for the period between time T1 and time T2. There is of course some volatility
(or pair of volatilities) that will give the correct price for any given compound option. But the price of
a compound option given by the Black-Scholes model is highly sensitive to the volatility and any
procedure that involves estimating the “correct” volatility is dangerous and liable to give rise to
significant errors.

Overall, though it seems that LVM is still a much better choice here than BSM to price such a product
which has a relatively minor dependency on the Transition density of Stock price. The fact of being
well calibrated to the skew appears more important than transition distributions in computing this
price, so that LVM and SVM give similar prices while Black and Scholes is far away. This is a situation
of low residual model risk once we have chosen a model that guarantees good calibration. However,
its performance takes quite a hit when we get to more path-dependent products such as Barrier
options as we see in the next section.

Barrier Options
Barrier options are even more dependent on transition densities. How so? Well, what makes a
Barrier option different from a Vanilla European option is the fact that the stock price must also not
cross the barrier throughout the life of the option. Thus, the final payoff now depends on not only
the value the stock price takes at option maturity but it’s also conditional on the stock price staying
within the barrier. Hence, the conditional probability of the stock price S(t) reaching a certain value
S(TM) at option maturity TM provided it does not touch a barrier H during its lifetime is required to
calculate the payoff. And, then if we generalize it to a case of say an up-and-out barrier call option
with strike K & with multiple monitor times T1, T2, … ,TM and each with a different Barrier level H1, H2,….,
HM. , then the price of such an option would be expressed as below

Again, as complicated as it looks, the above equation is actually pretty straightforward. Simply put, it
states that the payoff of the barrier option we described above would be the discounted value of the
difference of the Expected Stock price at maturity & the strike price K conditional on the Stock price
at the various monitor times lying below the corresponding Barrier levels. And then this is multiplied
by the probabilities of those Stock prices actually lying below the respective barrier levels. Thus, it’s
not just 1 transition density involved here but multiple ones to cater to the multiple barrier
conditions that need to be satisfied here.

Hull and Suo price a barrier option with a range of barriers and K = 90% or 100% of S(0). In this case
the difference between the LVM price and the SVM price can be almost 50% of the SVM price, and
this difference can be much higher than the error performed by a simplistic Black and Scholes model
calibrated only at ATM. This reveals a much higher model risk. Basis all our prior discussion, we do
expect this kind of divergence because as we said the Barrier option is a product that has a much
more complicated dependence on the Transition densities compared to the relatively simpler Call-
on-Call compound option we discussed previous to this.

Now, how does the comparison to the BSM model prices turn out in this case? Well, although not
quite as high as the difference between LVM & SVM as mentioned above, as here also the BSM
prices were observed to be substantially lower. To what factors can we attribute these differences?
Well, in case of this Barrier option, the high convexity shown by the Black–Scholes price as a function
of volatility is a big factor. But to understand exactly why, first we need to make use of a very useful
property of SVM prices which states that when there is zero correlation between the asset price and
volatility, the stochastic volatility price of a barrier option is its Black–Scholes price integrated over
the probability distribution of the average variance rate during the life of the option. Now, there’s a
detailed series of steps that go into establishing this property & it’s all covered in detail in the paper
“The Pricing of Options on Assets with Stochastic Volatilities” by Hull & White. I do not wish to include the entire
mathematical derivation here so as not to digress from the topic-at-hand. However, the approach
followed is quite simple enough as shown below –

 We know the price of a call-option can be written as present value of the expected terminal
value of option payoff discounted at the risk-free rate.
 We write the above expectation in terms of the Probability distribution of the Terminal stock
price conditional on the value of the current stock price & instantaneous variance
 We express the above Probability distribution of the Terminal stock price as the product of
the conditional distribution of the Terminal stock price given the average variance rate AND
the conditional distribution of the average variance rate given the instantaneous variance.
 Finally, we rewrite the call option price in terms of an integral wrt the average variance rate
of a term which via some mathematical arguments can be shown to be the Black-Scholes
price for a call option on a security with the same variance as the average variance
rate above.

Now because of this short digression above, we’re now able to understand the exact impact of the
above-mentioned convexity. We know the BSM prices of barrier option have high convexity to the
volatility due to the fact that as volatility increases, the probability of the underlying asset hitting the
barrier also increases, impacting the option's value in a non-linear fashion. This convexity therefore
leads to the SVM value of the option increasing as the volatility of the volatility increases in the zero-
correlation case. For the equity index, the correlation between stock price and volatility is negative
rather than zero. This increases the value of the option still further because high stock prices tend to
be associated with low volatilities making it less likely that the barrier will be hit.

Now, having understood the impact of this convexity, let’s try to apply the same logic to further
understand the differences between the LVM & SVM prices. Since, compared to SVM which is driven
by 2 stochastic factors, the LVM is driven by only 1 hence it’s obvious that LVM will not display as
wide a range of vols as SVM & hence it gives lower price than SVM. Essentially, in spite of capturing
part of it, LVM does not capture well the effect of the negative correlation that exists between a
stock and its volatility due to its reliance on only 1-factor. The correlation between stocks and their
volatilities is actually negative, and it tends to become more negative when during crises, the prices
go down while volatilities go up.

Concluding Remarks
In general, we observe the pattern that as we move further away from Vanilla European products
that depend on just the terminal distribution of stock price, the worse the LVM gets compared to
SVM. The thing which LVM excels at is fitting to European options very well where the density is
unconditional. In that sense, even an exotic option, whose payoff is contingent on the asset price at
just one time is always correctly priced by the LVM. However, it does not do well with conditional
distributions as we showed in this article. The more the path-dependence of the product, the more
LVM struggles to provide accurate prices. Hence, the model risk in using LVM to price such heavily-
path dependent exotics and perhaps, even a Black-Scholes model might possibly be a better choice
than LVM to price those type of products. In fact, more of such similar new pieces of research had
started to emerge around the time the paper by Hull & Suo was written which led to a somewhat of
a decline in the enthusiasm for local volatility models.
Now, here, despite the detailed discussion on the model risk, we’ve actually glossed over another
major source of model risk – To be able to use the Breeden-Litzenberger approach & infer the full
probability distribution of the terminal spot price, we needed the full continuum of option prices.
But obviously, we can observe only a limited set of option prices in the market. Hence, at that point
we’d need to perform some form of interpolation/extrapolation between the market-observed
points to be able to generate a full surface which can then be used to infer the distribution. So, it’s
quite apparent to see that the choice of this interpolation/extrapolation method would impact the
inferred distribution function & hence, the Local volatility function. These kinds of issues will be
discussed in detail separately in a future article.